Economic Indicators For The Do-It-Yourself Investor

Economic indicators are some of the most valuable tools investors can place in their arsenals. Consistent in their release, wide in their scope and range, metrics such as the Consumer Price Index (CPI) and written reports like the "beige book" are free for all investors to inspect and analyze. Policymakers, most notably those at the Federal Reserve, use indicators to determine not only where the economy is going, but how fast it's getting there.

Admittedly, economic indicator reports are often dry and the data is raw. In other words, information needs to be put into context before it can be helpful in making any decisions regarding investments and asset allocation, but there is valuable information in those raw data releases. The various government and non-profit groups that conduct the surveys and release the reports do a very good job of collating and cohesively presenting what would be logistically impossible for any one investor do to on his or her own. Most indicators provide nationwide coverage and many have detailed industry breakdowns, both of which can be very useful to individual investors.

In this article, we'll touch on the most important aspects of economic indicators and how they relate to individual investors. (For more detailed information, see Economic Indicators To Know.)

What is an economic indicator?
In its simplest form, an indicator could be considered any piece of information that can help an investor decipher what is going on in the economy. The U.S. economy is essentially a living thing; at any given moment, there are billions of moving parts - some acting, others reacting. This simple truth makes predictions extremely difficult - they must always involve a large number of assumptions, no matter what resources are put to the task. But with the help of the wide range of economic indicators, investors are better able to gain a better understanding of various economic conditions.

There are also indexes for coincident indicators and lagging indicators, the components of each are based on whether they tend to rise during or after an economic expansion. (For related reading, see What are leading, lagging and coincident indicators? What are they for?)

Use in Tandem, Use in Context
Once an investor understands how various indicators are calculated and their relative strengths and limitations, several reports can be used in conjunction to make for more thorough decision-making. For example, in the area of employment, consider using data from several releases; by using the hours-worked data (from the Employment Cost Index) along with the Labor Report and non-farm payrolls, investors can get a fairly complete picture of the state of the labor markets. Are increasing retail sales figures being validated by increased personal expenditures? Are new factory orders leading to higher factory shipments and higher durable goods figures? Are higher wages showing up in higher personal income figures? The savvy investor will look up and down the supply chain to find validation of trends before acting on the results of any one indicator release. (For related reading, check out Surveying The Employment Report.)

Personalizing Your Research
Some people may prefer to understand a couple of specific indicators really well and use this expert knowledge to make investment plays based on their analyses. Others may wish to be a jack of all trades, understanding the basics of all the indicators without relying on any one too much. A retired couple living on a combination of pensions and long-term Treasury bonds should be looking for different things than a stock trader who rides the waves of the business cycle. Most investors fall in the middle, hoping for stock market returns to be steady and near long-term historical averages (about 8-10% per year).

Knowing what the expectations are for any individual release is helpful, as well as generally knowing what the macroeconomic forecast is believed to be at become important functions. Forecast numbers can be found at several public websites, such as Yahoo! Finance or MarketWatch. On the day a specific indicator release is made, there will be press releases from news wires such as the Associated Press and Reuters, which will present figures with key pieces highlighted. It is helpful to read a report on one of the newswires, which may parse the indicator data through the filters of analyst expectations, seasonality figures and year-over-year results. For those that use investment advisors, these advisors will probably analyze recently-released indicators in an upcoming newsletter or discuss them during upcoming meetings. (For articles about analyzing and using this data, see Trading On News Releases and A Top-Down Approach To Investing.)

Inflation Indicators - Keeping a Watchful Eye
Many investors, especially those who invest primarily in fixed-income securities, are concerned about inflation. Current inflation, how strong it is, and what it could be in the future are all vital in determining prevailing interest rates and investing strategies.

There are several indicators that focus on inflationary pressure. The most notable in this group are the Producer Price Index (PPI) and the Consumer Price Index (CPI). The PPI comes out first in any reporting month, so many investors will use the PPI to try and predict the upcoming CPI. There is a proven statistical relationship between the two, as economic theory suggests that if producers of goods are forced to pay more in production, some portion of the price increase will be passed on to consumers. Each index is derived independently, but both are released by the Bureau of Labor Statistics. Other key inflationary indicators include the levels and growth rates of the money supply and the Employment Cost Index (ECI). (To learn more, read The Consumer Price Index: A Friend To Investors.)

Economic Output - Stock Investors Inquire Within
The gross domestic product(GDP) may be the most important indicator out there, especially to equity investors who are focused on corporate profit growth. Because GDP represents the sum of what our economy is producing, its growth rate is targeted to be in certain ranges; if the numbers start to fall outside those ranges, fear of inflation or recession will grow in the markets. To get ahead of this fear, many people will follow the monthly indicators that can shed some light on the quarterly GDP report. Capital goods shipments from the Factory Orders Report is used to calculate producers' durable equipment orders within the GDP report. Indicators such as retail sales and current account balances are also used in the computations of GDP, so their release helps to complete part of the economic puzzle prior to the quarterly GDP release. (For related reading, see The Importance Of Inflation And GDP and Understanding the Current Account In The Balance Of Payments.)
Other indicators that aren't part of the actual calculations for GDP are still valuable for their predictive abilities - metrics such as wholesale inventories, th "beige book", the Purchasing Managers' Index (PMI) and the Labor Report all shed light on how well our economy is functioning. With the assistance of all this monthly data, GDP estimates will begin to tighten up as the component data slowly gets released throughout the quarter; by the time the actual GDP report is released, there will be a general consensus of the figure. If the actual results deviate much from the estimates, the markets will move, often with high volatility. If the number falls right into the middle of the expected range, then the markets and investors can collectively pat themselves on the back and let prevailing investing trends continue.

Mark Your Calendar
Sometimes indicators take on a more valuable role because they contain very timely data. The Institute of Supply Management's PMI report, for instance, is typically released on the first business day of every month. As such, it is one of the first pieces of aggregate data available for the month just ended. While not as rich in detail as many of the indicators to follow, the category breakdowns are often picked apart for clues to things such as future Labor Report details (from the employment survey results) or wholesale inventories (inventory survey).

The relative order in which the indicators are presented does not change month to month, so investors may want to mark a few days on their monthly calendars to read up on the areas of the economy that might change how they think about their investments or time horizon. Overall, asset allocation decisions can fluctuate over time, and making such changes after a monthly review of macro indicators may be wise.

Conclusion
Benchmark pieces of economic indicator data arrive with no agenda or sales pitch. The data just is - and that is hard to find these days. By becoming knowledgeable about the what's and why's of the major economic indicators, investors can better understand the economy in which their dollars are invested, and be better prepared to revisit an investment thesis when the timing is right.

While there is no one "magic indicator" that can dictate whether to buy or sell, using economic indicator data in conjunction with standard asset and securities analysis can lead to smarter portfolio management for the do-it-yourself investor.

What You Should Know About Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase as reported in the Consumer Price Index (CPI), generally prepared on a monthly basis by the U.S. Bureau of Labor Statistics. As inflation rises, purchasing power decreases, fixed-asset values are affected, companies adjust their pricing of goods and services, financial markets react and there is an impact on the composition of investment portfolios.

Inflation, to one degree or another, is a fact of life. Consumers, businesses and investors are impacted by any upward trend in prices. In this article, we'll look at various elements in the investing process affected by inflation and show you what you need to be aware of. (For background reading, see All About Inflation.)

Financial Reporting and Changing Prices
Back in the period from 1979 to 1986, the Financial Accounting Standards Board (FASB) experimented with "inflation accounting", which required that companies include supplemental constant dollar and current cost accounting information (unaudited) in their annual reports. The guidelines for this approach were laid out in Statement of Financial Accounting Standards No. 33, which contended that "inflation causes historical cost financial statements to show illusionary profits and mask erosion of capital."

With little fanfare or protest, SFAS No. 33 was quietly rescinded in 1986. Nevertheless, serious investors should have a reasonable understanding of how changing prices can affect financial statements, market environments and investment returns.

Corporate Financial Statements
In a balance sheet, fixed assets - property, plant and equipment - are valued at their purchase prices (historical cost), which may be significantly understated compared to the assets' present day market values. It's difficult to generalize, but for some firms, this historical/current cost differential could be added to a company's assets, which would boost the company's equity position and improve its debt/equity ratio. In terms of accounting policies, firms using the last-in, first-out (LIFO) inventory cost valuation are more closely matching costs and prices in an inflationary environment. Without going into all the accounting intricacies, LIFO understates inventory value, overstates the cost of sales, and therefore lowers reported earnings. Financial analysts tend to like the understated or conservative impact on a company's financial position and earnings that are generated by the application of LIFO valuations as opposed to other methods such as first-in, first-out (FIFO) and average cost. (To learn more, read Inventory Valuation For Investors: FIFO And LIFO.)

Market Sentiment
Every month, the U.S. Department of Commerce's Bureau of Labor Statistics reports on two key inflation indicators: the Consumer Price Index (CPI) and the Producer Price Index (PPI). These indexes are the two most important measurements of retail and wholesale inflation, respectively. They are closely watched by financial analysts and receive a lot of media attention.

The CPI and PPI releases can move markets in either direction. Investors do not seem to mind an upward movement (low or moderating inflation reported) but get very worried when the market drops (high or accelerating inflation reported). The important thing to remember about this data is that it is the trend of both indicators over an extended period of time that is more relevant to investors than any single release. Investors are advised to digest this information slowly and not to overreact to the movements of the market. (To learn more, read The Consumer Price Index: A Friend To Investors.)

Interest Rates
One of the most reported issues in the financial press is what the Federal Reserve does with interest rates. The periodic meetings of the Federal Open Market Committee (FOMC) are a major news event in the investment community. The FOMC uses the federal funds target rate as one of its principal tools for managing inflation and the pace of economic growth. If inflationary pressures are building and economic growth is accelerating, the Fed will raise the fed-funds target rate to increase the cost of borrowing and slow down the economy. If the opposite occurs, the Fed will push its target rate lower. (To learn more, read The Federal Reserve.) All of this makes sense to economists, but the stock market is much happier with a low interest rate environment than a high one, which translates into a low to moderate inflationary outlook. A so-called "Goldilocks" - not too high, not too low - inflation rate provides the best of times for stock investors.

Future Purchasing Power
It is generally assumed that stocks, because companies can raise their prices for goods and services, are a better hedge against inflation than fixed-income investments. For bond investors, inflation, whatever its level, eats away at their principal and reduces future purchasing power. Inflation has been fairly tame in recent history; however, it's doubtful that investors can take this circumstance for granted. It would be prudent for even the most conservative investors to maintain a reasonable level of equities in their portfolios to protect themselves against the erosive effects of inflation. (For related reading, see Curbing The Effects Of Inflation.)

Conclusion
Inflation will always be with us; it's an economic fact of life. It is not intrinsically good or bad, but it certainly does impact the investing environment. Investors need to understand the impacts of inflation and structure their portfolios accordingly. One thing is clear: depending on personal circumstances, investors need to maintain a blend of equity and fixed-income investments with adequate real returns to address inflationary issues.

How Dividends Work For Investors

If we had published this article during the dotcom boom of the late 1990s, there's no doubt we would have been laughed at. Back then, everything was going up in double-digit percentages, and nobody wanted to fool around with the meager 2-3% gain from dividends. After all, we were in the new economy: the rules had changed and companies that paid dividends were "too old economy".

As Bob Dylan once sang, "The times, they are a-changin'." After the bull market of the '90s ended, the fickle mob once again found dividends attractive. For many investors, dividend-paying stocks have come to make a lot of sense. In this article, we'll explain what dividends are and how you can make them work for you.

Background on Dividends
A dividend is a cash payment from a company's earnings, announced by a company's board of directors and distributed among stockholders. In other words, dividends are an investor's share of a company's profits, given to him or her as a part-owner of the company. Aside from option strategies, dividends are the only way for investors to profit from ownership of stock without eliminating their stake in the company.

When a company earns profits from operations, management can do one of two things with the profits. It can choose to retain them - essentially reinvesting them into the company with the hopes of creating more profits and thus further stock appreciation. The other alternative is to distribute a portion of the profits to shareholders in the form of dividends. (Management can also opt to repurchase some of its own shares - a move that would also benefit shareholders. Read more about it in The Lowdown on Stock Buybacks.)

A company must keep growing at an above-average pace to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a company's growth slows, its stock won't climb as much, and dividends will be necessary to keep shareholders around. This growth slowdown happens to virtually all companies after they attain a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30-40% like a small cap, regardless of how much money is plowed back into it. At a certain point, the law of large numbers makes a mega-cap company and outperforming growth rates which outperform the market an impossible combination.

The changes witnessed in Microsoft in the last few years are a perfect illustration of what can happen when a firm's growth levels off. In Jan 2003, the company finally announced that it would pay a dividend: Microsoft had so much cash in the bank that it simply couldn't find enough worthwhile projects in which to invest - you can't be a high-flying growth stock forever!

The fact that Microsoft started to pay dividends did not signal the company's demise; it simply indicated that Microsoft had become a huge company and had entered a new stage in its life cycle, which meant it probably would not be able to double and triple at the pace it once did.

Dividends Won't Mislead You
By choosing to pay dividends, management is essentially conceding that profits from operations are better off being distributed to the shareholders than being put back into the company. In other words, management feels that reinvesting profits to try to achieve further growth will not offer the shareholder as high a return as a distribution in the form of dividends.

There is another motivation for a company to pay dividends: a steadily increasing dividend payout is viewed as a strong indication of a company's continuing success. The great thing about dividends is that they can't be faked. They are either paid or not paid, increased or not increased.

This isn't the case with earnings, which are basically an accountant's best guess of a company's profitability. All too often, companies must restate their past reported earnings because of aggressive accounting practices, and this can cause considerable trouble for investors, who may have already based future stock price predictions on these (unreliable) historical earnings. (To learn more about earnings manipulation, read Understanding Pro-Forma Earnings and Cooking the Books 101.)

Expected growth rates are also unreliable. A company can talk a big game about wonderful growth opportunities that will pay off several years down the road, but there are no guarantees that it will make the most of its reinvested earnings. When a company's robust plans for the future (which impact its share price today) fail to materialize, your portfolio will very likely take a hit.

However, you can rest assured that no accountant can restate dividends and take back your dividend check. Moreover, dividends can't be squandered away by the company on business expansions that don't pan out. The dividends you receive from your stocks are 100% yours. You can use them to do anything you like: pay down your mortgage, spend it as discretionary income or buy the stock of a company you think has better growth prospects.

Who Determines Dividend Policy?
The company's board of directors decides what percentage of earnings will be paid out to shareholders, and then puts the remaining profits back into the company. Although dividends are usually dispersed quarterly, it is important to remember that the company is not obligated to pay a dividend every single quarter. In fact, the company can stop paying a dividend at any time, but this is rare, especially for a firm with a long history of dividend payments.

If people were used to getting their quarterly dividends from a mature company, a sudden stop in payments to investors would be akin to corporate financial suicide. Unless the decision to discontinue dividend payments was backed by some kind of strategy shift, say investing all retained earnings into robust expansion projects, it would indicate that something was fundamentally wrong with the company. For this reason, the board of directors will usually go to great lengths to keep paying at least the same dividend amount.

How Stocks That Pay Dividends Resemble Bonds
When assessing the pros and cons of dividend-paying stocks, you will also want to consider their volatility and share price performance as compared to those of outright growth stocks that pay no dividends. (For further reading, see The Power of Dividend Growth.)

Because public companies generally face adverse reactions from the marketplace if they discontinue or reduce their dividend payments, investors can be reasonably certain they will receive dividend income on a regular basis, for as long as they hold their shares. Therefore, investors tend to rely on dividends in much the same way that they rely on interest payments from corporate bonds and debentures.

Since they can be regarded as quasi-bonds, dividend-paying stocks tend to exhibit pricing characteristics that are moderately different from those of growth stocks. This is because they provide regular income, similar to a bond, but still provide investors with the potential to benefit from share price appreciation if the company does well.

Investors looking for exposure to the growth potential of the equity market, combined with the safety of the (moderately) fixed income provided by dividends, should consider adding stocks with high dividend yields to their portfolio. A portfolio with dividend-paying stocks is likely to see less price volatility than a growth stock portfolio.

Conclusion
A company can't keep growing forever. When it reaches a certain size and exhausts its growth potential, distributing dividends is perhaps the best way for management to ensure shareholders receive a return from the company's earnings. A dividend announcement may be a sign that a company's growth has slowed, but it is also evidence of a sustainable capacity to make money. This sustainable income will likely produce some price stability when paid out regularly as dividends. Best of all, the cash in your hand is proof that the earnings are really there, and you can reinvest or spend them as you see fit.